Stop Overpaying for Acquisitions

Karl Stark and Bill Stewart are managing directors and co-founders of Avondale, a strategic advisory firm focused on growing companies. Avondale, based in Chicago, is a high-growth company itself and is a two-time Inc. 500 honoree.

We all want to grow our business, which often leads to this question: Why don’t we just buy our way to growth? It’s easier to buy than to build, right?

The short answer is, not really. In fact, this sort of logic usually leads management teams to overpay for an acquisition. This may explain why most acquisitions destroy shareholder value instead of creating it.

Let’s start with one fundamental finance point that would-be acquirers often ignore. When you buy a company, you are paying the current owners for the present value of all the future profits that the business is expected to create. You must assume that the current owners understand the profits their business will create and if you paid them any less, they would choose to continue operating the business themselves rather than selling out. (Or, you must assume you are getting an amazing deal, which most acquirers believe but few actually achieve.)

This assumption sets a pretty high bar for success. As an acquirer, you have to believe that you can create even more profits than the current owners AND you would not be able to create those profits on your own.

Management teams often assert their own growth strategy as a justification for an acquisition. Reasons include entering a new geography, acquiring new customers, or gaining access to new product lines. The problem is, to justify these reasons, you must believe you will receive more economic benefit from buying a company vs. building a product or service line on your own.

Consider approaching the issue from a slightly different angle by asking these four questions:

How can we enter the new geography or market on our own?

Can we hire the people we need (potentially from the proposed target company)?

Do we need an acquisition to acquire customers or can we just offer prospects a better product/solution ourselves?

Can we build a new product, procure it, or enter a strategic partnership to sell it

The best management teams use these questions to uncover profitable organic opportunities or identify more targeted acquisition opportunities that allow them to create far more value than they would otherwise. At minimum, this approach minimizes the pursuit of expensive, value-destroying acquisitions.

You can still be acquisitive–and create a lot of value in doing so–if your M&A strategy begins with a hard look at organic growth opportunities.